Can the SEC fix target-date funds?

Many retirement savers own the funds, but few understand how they work

Target-date mutual funds, TDFs for short, are perhaps the most widely held but least understood packaged-for-retirement investment in the world.

The Securities and Exchange Commission (SEC) wants to change that. They want investors to better understand the TDFs they own or might own in their 401(k) and other types of retirement accounts.

And to that end, the SEC earlier this month reopened the public comment period for its TDF regulations, which were first proposed in 2010 but haven’t yet been completed. (Read the original proposal.)

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According to the SEC, that proposed rule would generally require TDFs to more prominently disclose the fund’s asset allocation at the target date, say 2025 or 2050. (The target date is typically intended to coincide with the date the investor expects to retire.) And that disclosure would have to be placed adjacent to the fund’s name the first time the name appears in marketing materials.

The proposal also would require marketing materials for TDFs to include a table, chart, or graph depicting the fund’s asset allocation over time. TDFs often reduce the percent invested in stocks as the fund moves closer to its target date. Experts often refer to this as the TDF’s glide path.

In the main, experts praise the SEC’s efforts.

“High level, I like the idea of providing the information, since target-date funds are perceived by many investors as ‘black boxes’ that are difficult to understand,” said David Blanchett, head of retirement research for Morningstar Investment Management.

Others agree. “I think it’s a great idea because it removes the ‘ignorance’ argument,” said Ron Surz, the president and CEO of Target Date Solutions and co-author of a book about target-date funds. “The SEC should require this disclosure.”

Great idea or not, here’s what happened most recently. The Investment Advisory Committee (IAC), a group of regulators, consumer advocates, academics and others who advise the SEC on matters of concern to consumers, earlier this month recommended a number of changes to the proposed TDF regulations. And that has caused the SEC to go back to the drawing board.

Mapping out a ‘glide path’

The IAC said, for instance, that the SEC should develop a glide-path illustration for TDFs that is based on a standardized measure of fund risk as either a replacement for or supplement to its proposed asset-allocation glide-path illustration.

In its letter, the IAC suggested that a glide-path illustration based on an appropriate, standardized measure of fund risk would be both more accurate and more flexible than a glide-path illustration based on asset allocation alone.

The IAC also suggested that the two approaches could be designed to work together: “If the fund is designed around a target risk level, illustrated through an appropriate risk glide path, the fund could also be required to disclose what the expected asset allocation would be to produce the desired risk level and explain that the asset allocation may vary, and other risk management practices may be employed, to maintain that target risk level,” the IAC wrote.

Where a fund bases its approach on a target asset allocation, the fund could be required to show the expected risk level associated with that asset allocation over the life of the investment. In each case, the illustrations would need to be periodically updated to reflect actual market experience and any changes in management strategy, the IAC wrote.

A standard methodology

In addition, the IAC said the SEC should adopt a standard methodology or methodologies to be used in both the risk-based and asset-allocation glide-path illustrations.

Wrote the IAC: “A primary purpose of the glide path illustration is to allow side-by-side comparisons of target-date fund risks…we believe this is better achieved through a risk-based glide-path illustration than an asset-allocation glide-path illustration, though we recognize that both may have their place. To promote comparability, risk-based illustrations should be based on a standardized measure of risk. Currently, no such standard exists, though a variety of accepted risk measures exist and are in use today.”

In addition, the IAC stated that the SEC, in determining the appropriate risk measure to use in a risk-based glide path illustration, should focus on factors such as maximum exposure to loss or volatility of returns that are directly relevant to the primary concerns of those approaching retirement.

The committee said the SEC should require TDF prospectuses to disclose and clearly explain the policies and assumptions used to design and manage the target-date offerings to attain the target risk level over the life of the fund.

The IAC did say it strongly supports the SEC’s proposal to require TDF marketing materials to include a warning that the fund is not guaranteed and that losses are possible, including at or after the target date. But it also said the SEC should consider testing various approaches to providing this disclosure to determine the most effective approach and then mandate that approach in the final rule.

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